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NETFLIX.COM, INC.

ANSWERS1 PART 1 of 2 (4/15/10)

At the time of the case, Netflix.com delivers movies in DVD format to subscribers using the
Internet and the U.S. mail. During its first three years of operation, the company has been
successful and plans an IPO in July 2000. Because of large expenses associated with initially
acquiring new subscribers, however, Netflix has never shown a profit. Following the collapse of
the NASDAQ market in spring 2000, Reed Hastings, the CEO, is forced to consider withdrawing
the company’s planned IPO. Barry McCarthy, the Netflix CFO (a Wharton MBA), is asked to
reevaluate Netflix’s projected cash flow requirements and to suggest modifications to the
existing business model that would improve the company’s projected cash flows. McCarthy
must strike a delicate balance between generating near-term positive cash flow and sustaining the
high rate of growth necessary for the company to achieve its long term objectives.

Q1a. Describe the key aspects of Netflix’s business: What does it sell, to whom, and how?
(1 pt)

WHAT DOES NETFLIX SELL?


At the time of the case (July 2000), Netflix operates an Internet-based, unlimited rental,
subscription, U.S. mail-based service for new release and older DVD movies. Hastings,
Netflix’s CEO, views Netflix as selling a combination of the services provided by a
traditional video store such as Blockbuster, and a subscription cable TV service such as
HBO. It uses DVDs rather than VHS videos because DVDs are small, durable, cheap to
mail, and the next wave in video recording and distribution.

TO WHOM?
Initially, Netflix appealed mostly to the technologically savvy early Internet adopter, that
is, most of the population of the San Francisco Bay area where Netflix began.
As the Internet became a common man’s arena, Netflix increasingly sold its subscription
service to anyone with an Internet connection and a mailbox.

HOW? (picture below not time of case vis-à-vis # titles)

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Some material in these answers draws on ―NetfFlix – Going Public,‖ Stanford GSB case E-155 (version 6/15/03).

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Subscribers learn about Netflix through technologically savvy friends, or in stores where
DVD players were sold. They can sign up either online at www.netflix.com, or by
completing and returning to Netflix the advertising card in their new DVD player box.
They get the first month free. After that, they pay a flat $19.95 per month in advance.
They can cancel anytime.
When subscribers sign up, they provide Netflix with their initial list of all the movies they
would like to see going forward. Netflix then sends them the first four movies.
When the subscriber has finished with a movie, he/she sends it back to Netflix in a
prepaid and pre-addressed U.S. mail mailer that came with the first four movies. When
Netflix gets the mailer, it puts the next DVD in the subscriber’s movie list into a new
mailer and immediately sends it to the subscriber. The subscriber can have no more than
four movies out at a time.
Netflix capitalizes on the rapid acceptance by U.S. consumers of DVD players.
Netflix keeps its customer acquisition costs to a minimum by cutting deals with most of
the leading DVD manufacturers (Sony, Toshiba, Panasonic, RCA) for them to include
Netflix promotional offers with the sale of new DVD players.
Netflix developed proprietary software through which it enhanced its customers’
experience and improved its own operational efficiency. For example, the company’s
CineMatch technology created a custom online interface for each subscriber and
leveraged the Internet by offering movie recommendations based on a database of ratings
collected from its customers. Special software also enabled Netflix to achieve
operational efficiency through automating the tracking and routing of titles to and from
the company’s distribution centers.

Q1b. Identify the business/economic means through which Netflix intends to create value
for its customers—viz., what is Netflix’s “value proposition”? (1 pt)

Netflix’s model creates value for its customers in three key ways:
Value. Free trial month. Unlimited DVD rentals for a flat $19.95 fee per month. No late
fees. Free shipping. You can cancel at any time.
Convenience. No due dates. No schlepping out to Blockbuster in the rain only to find
that they don’t have the movie you want. 1-2 day home delivery through regular U.S.
mail. Prepaid, pre-addressed envelopes provided by Netflix to make it easy for you.
Perfect for couch potatoes! (As Hastings once commented, ―With 800,000 employees
delivering to 100 million homes six days a week, [U.S.] mail is the ultimate digital
distribution network.‖2)
Selection. Over 5,800 titles to choose from at the time of the case, and clearly more
being added every day. More than just new releases. Powerful online browsing, search,
and personal-profile based recommendations.

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Stone, Brad, ―Movies in Your Mailbox,‖ Newsweek, 3/13/03.

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Q2. What are the major business risks that Netflix faces at the time of the case? (2.5 pts)

In the near term, the major business risk that Netflix faces (like most young, fast growing
technology-centric companies) is RUNNING OUT OF CASH. Netflix may run out of
cash before it can complete its ―small smile‖ into generating positive free cash flows
because it can no longer believe it will automatically be able to attract more private
equity funding and/or undertake an IPO. The IPO window was firmly nailed shut in July
2000, and the case states ―Investment bankers indicated to Hastings that Netflix would
need to show positive cash flows within a twelve-month horizon in order to have a
successful offering.‖ So it’s more or less on its own for the next year or two…

Beyond the aggregate risk of running out of cash:

Netflix faces two types of competitive threats:


Small, directly competitive ventures that are attempting to start similar online
subscription services (e.g., Rentmydvd.com and dvdovernight.com).
Established rental outlets and retailers such as Blockbuster Video and Amazon.com.
Blockbuster dominates the video rental market with close to a 50% share.
Potential new entrants such as WalMart.

In the longer term, Netflix faces the threats of:


Failing to achieve a critical mass of subscribers. Arguably, particularly if you are a
marketing person, Netflix’s key long-term asset is its BRAND. Now and in the long-
term, Netflix wants to be the company you think of when you think of watching a movie
or a show or a series, particularly at home. If it can become THE brand in this regard,
then it may be able to successfully transition from DVD rentals through the mail to VOD
or whatever new technologies will be coming in the future.
Video-on-demand (VOD). Most analysts believe that eventually it will be the case that
you will be able to sit on your sofa, and using your TV remote, access an unlimited
library of movies for instant viewing, stopping, rewinding, etc. However, at the time of
the case, this was more theory than reality.
Movie studios. Netflix may be unable to either persuade the movie studios to do business
with it, or even if they do successfully persuade the movie studios to do business with
them, Netflix may have zero market power—be controlled by—the whims and dictates of
these 800lb gorillas.
Piracy. Most analysts also believe that because of the Internet, eventually piracy will
become as big a problem for the movie industry as it has for the record industry. But
again, at the time of the case, this was science fiction, not science fact.

Other business risks that Netflix faces include:


Problems with DVD adoption. The issue here is not so much that DVDs will not be
adopted, but at what future rate. Small changes in DVD adoption rates relative to
expectations could have material effects of Netflix’s customer acquisition rates.
Problems with customer retention—understanding, controlling and reducing ―churn.‖

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A potential stigma from having filed but then withdrawn its IPO in mid-2000.
Growing too rapidly—like trying to drive a car too quickly, the firm could spin out of
control (managerially, financially, operationally, etc.)

Q3. “Because the Netflix business model focused on the acquisition and retention of
individual subscribers, McCarthy projected future Netflix financing requirements
using a subscriber model. First, he modeled the expected cash flows from a newly
acquired subscriber, including the subscription fees paid, the expected number of
discs rented, the costs associated with shipping and disc acquisition, and any other
cash flows that varied directly with the acquisition or loss of an individual
subscriber. Second, he modeled the likelihood that any given subscriber would be
retained over the forecast horizon.” Create a set of spreadsheets that achieve these
modeling goals. (12.5 pts with each sheet worth 2.5 pts)

<< See EXCEL spreadsheets>>

In my opinion, the key elements of a good answer here are:


Identifying the major business drivers that affect cash flows for a single new subscriber.
Major on the majors in this simple-level outline. Leave the minors for later.
Presenting your sheets in a clear, easy-to-understand manner.
Making plain your assumptions and reasoning.
Using color to highlight cells that are parameters—that is, key inputs or assumptions that
may need to be changed.
Have a combination of numbers, text and pictures.

Q4a. How does the case demonstrate both internal and external financial statement
analysis? (1 pt)

Internal = Financial planning by the CFO of Netflix aimed at managing Netflix’s cash
flow smile.
External = Financial analysis by CFOs of competitors who at Netflix’s S-1 filing in 2000
get their first look at the business microeconomics of Netflix’s business. Or analysis by
movie studios looking to determine if Netflix really is going to be a sustainable business.

Q4b. Is the task asked of the CFO (McCarthy) by the CEO (Hastings) one that would fall
within the mainstream or the periphery of a typical CFO’s job description? (1 pt)

Yes. The task that Hastings sets McCarthy is ―To re-evaluate the cash flow requirements
of the company’s current business plan, to suggest modifications that would improve
projected cash flows, and to make a recommendation on whether the company should go
forward with its planned offering.‖ This is the kind of value that a good CFO delivers,
because he or she is primarily employed to make financing activities happen smoothly.

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Q4c. What skills does the case suggest are necessary for a successful CFO to have? (1 pt)

NOT necessarily to be a whiz at debits and credits! Rather, the job of the CFO is not to
run the company, or to make strategic decisions concerning the firm’s investing or
operating activities. Those responsibilities lie in the lap of the CEO and COO. But
clearly a good CFO will understand investing and operating activities, and will provide
the CFO with his or her thoughts as to how those activities can be best ―oiled‖ by superb
financing activities. Through careful modeling of the results of Netflix’s current business
plan, McCarthy is able to provide wise advice to the CEO and ultimately the Board of
Directors about the likely future success of the firm.

A fine example of the job description of today’s best CFOs is found in Ken Kaufman’s
article ―Value-Added Financial Management: The New CFO Job Description‖ in the
May 2003 issue of the Healthcare Financial Management Association’s Executive
Insights newsletter. In that article, Kaufman argues that value-added CFOs today need to
skillfully wear seven interrelated hats:

Chief financial planner


The importance of the CFO's role in financial planning cannot be overemphasized. A
solid financial plan, authored by the CEO and CFO, provides the company’s backbone,
linking its strategic mission and vision to measurable financial goals. A well-developed
financial plan helps the organization determine the critical relationship between strategy
and financial capability and achieve operating results that ensure financial equilibrium.

Chief allocator of capital


The CEO is responsible for establishing a vision for strategic capital investment that sets
forth what the organization wishes to accomplish given its mission. But the actual
process of allocating that capital should be the province of the CFO. The most important
financial decision made each year by senior management and ratified by the board is how
much capital to spend and on which initiatives the dollars will be spent.

Chief of capital structure and debt management


Expense management will always be important, but for the CFO, expense management
should start with interest-rate management, debt management, and the overall
management of sophisticated capital structures. Over time, capital-structure and cost-of-
capital decisions can affect a balance sheet by millions of dollars. "Plain vanilla"
finance—such as when an A-rating organization borrows money at a fixed interest rate
for 30 years and then forgets about it—is a thing of the past. Today's transactions require
daily attention to interest costs, manipulating the capital structure when opportunities
emerge to lower all-in capital costs.

Chief accounting officer


Finance in the world following Enron, WorldCom, and Tyco means that the CFO is first
and foremost the chief accounting officer. Financial leaders must act on the fact that
organizational credibility depends on the accuracy of financial statements. Although
major audit firms have tightened standards, significant accounting decision points remain

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for the CFO, including recognition of loss on investments, pension accounting,
accounting for acquisitions and divestitures, and accounting for derivative transactions.

Chief credit officer


CFOs must be the guardian of their firm’s credit quality, because an organization's long-
term competitive position today substantially depends on its ability to raise affordable
capital in the debt markets. This, in turn, is highly dependent on the organization's credit
rating and overall creditworthiness. It is often up to the CFO to resist the short-term
temptations to sacrifice strong balance sheets and A-category bond ratings for
incremental debt capacity and additional strategic investment.

Chief of the "heavy finance" department


Just as hospitals are full of clinical experts, CFOs must ensure that their finance
departments are fully staffed with "heavy finance" experts who enable the finance
department to demonstrate consistently exceptional performance. The finance department
should be a recognized player in critical strategic and financial decisions.

Chief defender of the firm’s financial integrity


Management must avoid significant financial defeats that harm the company’s financial
integrity. The mantra of the management team should be "anticipation, attention,
analysis, and action." The CEO, CFO, and other key executives, working as a team,
should examine each element of the organization's strategy and each capital investment to
anticipate negative outcomes, evaluate overall risk and performance, and take action to
ensure that any harm inflicted by a bad idea is limited to a single "bump in the road."

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POSTSCRIPT

1. Netflix’s “Little Smile”

2. Stock price performance